The myth of the small cap premium

“There are lots of reasons why investors get excited about small stocks, particularly in Australia,” a global asset manager stated in a report published in 2017.

These reasons include “the higher growth rates that smaller companies can achieve” and “the myriad of successful individual stock stories that abound.”

Many people dream about – and some repeatedly try – hitching their wagons to “the next Microsoft” (or Amazon, Apple, etc.) and riding it effortlessly to a fortune. For this or other reasons, “many investors in Australia are ... structurally overweight small-cap stocks ...”

In contrast, Leithner & Company’s investments have, since its establishment in 1999, gravitated from small towards mid and large caps.

We hardly shun small caps: indeed, they’re our two biggest current holdings; they also number among the companies on our “buy list.” Yet we’re mindful that, during the 21st century and relative to mid and large-cap indexes, the S&P/ASX Small Ordinaries Index (SOI) has been volatile and its long-term returns subpar.

If you’re greatly overweight small caps (on 30 September, the SOI comprised ca. 15% of Australian stocks’ total capitalisation of ca. $2.6 trillion; hence I regard portfolios comprising 30% or more small caps as “greatly overweight”), the risk rises that your results will disappoint.

They’ll probably also fluctuate unduly; in particular, they’ll likely suffer disproportionately during bear markets, crises and panics.

This article shows why investors should choose their small caps carefully and in moderation, and concentrate upon mid and large caps. But under certain infrequent conditions – which I specify – speculators who buy small caps can generate outsized short-term returns.

What is a small-cap?

If it’s one of the stocks that comprise the SOI, then I regard it as a small-cap.

“This index,” says Standard & Poor’s, “is designed to measure companies included in the S&P/ASX300, but not in the S&P/ASX100.”

More generally, I designate the top 20 (ranked by market cap) of the ca. 2,000 companies listed on the ASX as “large caps,” those ranked 21-100 as “mid-caps,” those ranked 101-300 as “small caps” and the remainder (roughly 1,700) as micro caps.

In the analysis that follows, I’ll refer to the S&P/ASX20 index as the large-cap index and the S&P/ASX100 as the mid-cap index.

This measurement of mid-caps is inexact because all components of the large-cap index are also components of the mid-cap index. The key thing for my purposes is that the large and small-cap indexes have no members in common.

Generally speaking, small caps aren’t minnows: on 30 September, the SOI’s total market capitalisation was $367 billion; its largest stocks’ caps exceeded $5 billion; its median component’s cap was $1.4 billion and its smallest member was $114 million.

Of its current constituents, 40 are in the Materials sector, which comprised a commensurate (20.5%) share of its total cap. But the Index as a whole is diversified: the weighting of Consumer Discretionary (15.5%) is almost as great, and Real Estate (13.4%), Financials (12.7%) and Information Technology (8.8%) are also significant segments.

Why we’ve gravitated from small caps

Since its establishment in 1999, Leithner & Co’s portfolios have increasingly comprised well-established, industry-leading and hence mostly very large enterprises.

We hold and seek to acquire shares of entities that develop, own and operate critical, long-life and world-class infrastructure; possess the managerial breadth and financial depth to withstand economic and financial vicissitudes (and to recover from their ravages); and are (and, we anticipate, will remain) major providers of essential goods and services.

No hard and fast rule is realistic and exceptions are therefore numerous, but large and mid-caps are more likely than small caps to possess these attributes.

Moreover, as value investors, we strive to derive cautious estimates of the values of businesses and their securities.

Again, plenty of exceptions exist, but the histories of small caps tend to be shorter and more erratic; they’re also generally more vulnerable to economic, financial and other shocks; hence their fortunes have been relatively variable.

Consequently, mid and large caps are typically more amenable to rigorous analysis and conservative valuation than small (never mind micro) caps. That’s one reason why our portfolio’s centre of gravity has shifted.

Short, medium and long term returns

A second reason is a major consequence of the first: over the past two decades, mid and large caps have generated higher returns than small caps. The chart below plots investments (excluding dividends) in three indexes: the S&P/ASX20, S&P/ASX100 and SOI.

Consider an investment of $100 in June 2004 in a portfolio that perfectly mimicked the small caps index: by September 2021 its market value grew to $179. That’s a compound rate of growth of 3.5% per year.

During this interval, investments of $100 each in the large-cap and mid-cap indices rose to $215 (4.4% per year) and $221 (4.8% per year) respectively.

Investments of $100 (ex-dividends) in three indexes since 2004

Not only has there been no “small-cap effect” in Australia: if anything, a “mid-cap effect” exists. The disparity between small caps and the rest is likely even bigger than the chart suggests.

As we’ll see below, large caps’ earnings – and thus dividends – have outstripped small caps’; as a result, on a total return basis small caps likely lag even further behind mid and large caps.

During both the 12 months and the five years to September 2021 the SOI has outperformed the other indexes (Table 1a).

Over intervals of ten years and longer, however, it’s lagged them. And over specific long-term periods, it’s been utterly crushed: between May and November 2007, for example, the small-cap investment exceeded $200; but as late as February 2016 it barely exceeded $100. That’s a loss of 50% over 8.5 years. 

Compound annual growth rates of three indexes over standard intervals since 2004

This table specifies when small caps have out- and under-performed:

1. Their returns have been strongest during economic booms – both before the GFC and after the GVC (Global Viral Crisis). Since May 2020, however, the S&P/ASX100 has outpaced the SOI.
2. In contrast, small caps significantly underperformed during the two busts.
3. Their underperformance isn’t solely a matter of crises in financial markets and recessions in the real economy. Not only did the SOI generate continuous – and cumulatively substantial – losses during the ca. five years to February 2016; it underperformed throughout the 8.5 years to December 2019.

Compound annual growth rates of three indexes over specified intervals since 2004

Small-cap volatility: a bumpy ride

Australian small caps haven’t just provided a slower long-term ride; in the short term, they’ve also delivered a bumpier one.

The table above plots the intra-month variability of each index since June 2004. In September of this year, for example, the SOI’s maximum was 3,466.6 and its minimum was 3,364.7; its intra-month variability was, therefore (3,466.6 - 3,364.7) ÷ 3,364.7 = 3.0%.

Of the three indexes, the SOI’s average variability has been largest (7.8%) and the S&P/ASSX100’s smallest (6.8%); the S&P/ASX20’s is 7.2%.

Not only have mid caps produced the biggest long-term return: they’ve generated the smallest intra-month volatility. In contrast, the SOI’s long-term return has been lowest and its intra-month fluctuation highest.

Intra-month variability in three indexes since 2004

Each index’s intra-month variability skyrocketed during the GFC and GVC, but during each crisis, the small-cap index's zoomed highest, as this chart shows.

Its maximum during the GFC was 51% in October 2008 (versus 38% for the large-cap index and 35% for the mid-cap index in December 2008).

Similarly, the small-cap index’s maximum variability during the Global Viral Crisis was 56% in March 2020 (versus 45% for the large-cap index and 48% for the mid-cap index in April 2020).

But it’s not merely a matter of turbulence during crises. The table below presents the index’s average intra-month variability during the same intervals as in the earlier tables.

With only one exception (the pre-GVC period from March 2016 to December 2019), the small-cap index's variability has exceeded the others’.

Table 2: Average Intra-Month Variability, Three Indexes, Specified Intervals since 2004

Why and when speculators might profitably trade small caps

I’ve identified three reasons why Leithner & Co is (and other long-term, buy-and-hold value investors should be) underweight small caps and overweight mid and large caps.

Small caps, in other words, tend to attract speculators. For brevity and simplicity, I contrast investors (who regard shares as means to own businesses, and regard shares’ prices only in relation to their values) from speculators (who mostly ignore businesses and their operations, and fixate upon the short-term fluctuation of shares’ prices without regard to the corresponding companies’ values).

Investors seek to gain over the long term (which I define as a period of five years or more), significantly and perhaps preponderantly through dividends, as the businesses prosper; speculators seek to profit over the short term (periods of less than one year) via the fluctuations of shares’ prices.    

I can’t emphasise it enough: no matter how experienced is the speculator, speculation is almost always – in the sense that he faces long odds – a loser’s game. Indeed, the “smarter” and more confident is the speculator, the more likely it is that he’ll lose.

For more on this, see Does high IQ make a better investor? and Experts can’t predict yet investors must plan: What, then, to do?.

Speculators face a well-nigh insuperable problem: in the short term, securities’ prices very seldom fluctuate systematically. Instead, they virtually always vary randomly.

The chart below provides a typical example. It plots the performance of the small-cap index versus the S&P/ASX20 over one-month and 12-month periods.

From August to September of this year, for example, the small-cap index's closing price fell from 3,568.8 to 3,472.9; that’s a decrease of 2.7%. The S&P/ASX20 dropped 3.6%.

Hence the small-cap index’s performance relative to its large-cap counterpart was -2.7% - (-3.6%) = 0.9 percentage points. In the chart, numbers greater than zero denote outperformance; those less than zero indicate underperformance.   

SOI outperformance versus S&P/ASX20, 1-month and 12-month, since 2004

The one-month series is a textbook example (apart from its sharply increased volatility during the GVC) of a random walk.

Its mean is -0.006, in 49.8% of its observations the SOI outperforms and in 50.2% it underperforms. Most importantly, over-and under-performance is distributed randomly throughout the series; in other words, it contains no cycles.

On a one-month basis, the small-cap index neither over- nor under-performs the large-cap index; hence the odds are high anybody who tries to arbitrage these indexes’ relative returns will, on average, have nothing to show for his efforts.

In three key respects, the 12-month series is different. First, its mean is -0.39 – more negative than the one-month series.

The extent of underperformance is thus more marked: in 45.9% of these periods the small-cap index outperforms, and in 54.1% it underperforms.

Second, this series’ standard deviation is relatively large (14.3% versus the one-month series’ 6.2%). Finally, the small-cap index's relative performance is NOT distributed randomly: in particular, the higher is its outperformance in a given month, the greater is the probability and degree of underperformance 12 months hence.

Conversely, the more marked is the underperformance at a given point, the greater is the outperformance in 12 months. This series, in short, is highly cyclical; in particular, it’s heavily mean-regressing.

Why should this systematic cyclicality interest speculators? On an average 12-month basis, the small-cap index underperforms. Consequently, anybody who randomly times repeated attempts to arbitrage the small-cap index's return relative to the large-cap index will, on average, lose money.

But given the 12-month series’ cyclicality, and assuming that it continues into the future, the astute speculator who systematically times his attempts to arbitrage these indexes’ relative returns can generate consistent outperformance.

When and how much? How to turn otherwise poor odds into favourable odds? To answer these questions, I ranked the observations plotted in the above chart according to the small-cap index's 12-month over- and underperformance.

I then divided these observations into five quintiles (i.e., ranked piles of observations, each of which, net of rounding, contains the same number of observations).

Next, for each observation, I computed the small-cap index's return, as well as its performance relative to the S&P/ASX20, during the next 12 months.

Finally, for each quintile, I computed the small-cap index’s average return and outperformance during the next 12 months. The table below summarises the results. One is critical:

If, during one of the 20% of months since 2004 when the small-cap index's 12-month return has been worst relative to the S&P/ASX20, you buy a basket of small caps that perfectly mimics the small-cap index, then during the next 12 months you can expect to receive an average return of 9.1%. 

That’s almost twice the SOI’s average 12-month return (4.6%); it also significantly exceeds the large and mid-cap indexes’ average 12-month returns (both are 5.0%). 

Specifying the SOI's outperformance

How to underperform systematically by buying the SOI? Buy when its 12-month return exceeds the small-cap index’s.

Reading the third and fourth columns from bottom to top, the relationship is clear: as the SOI’s current underperformance relative to large caps rises, so too does its subsequent outperformance.

Actually, that’s not exactly right and speculators should restrain themselves: the months that encompassed the GFC mostly fell into Quintile #2, and the GFC crushed small caps, such that this quintile’s actual average is -0.8%. Quintile #2’s mean in the table excludes these months and thereby reveals a strong monotonic relationship.

So the historically accurate rule is: “buy the small-cap index when its underperformance versus the large cap index reaches an extreme – unless there’s a crisis or panic during the next 12 months, in which case you’ll get clobbered.” Just as there's no free lunch, speculation is ultimately a loser's game.

Anticipating three criticisms

Criticism 1: “You’re Ignoring small caps’ prospective earnings growth”

“Australian small companies have a track record of offering higher earnings growth relative to their large-cap counterparts and other equity classes,” a proponent asserted earlier this year.

“Key reasons include greater exposure to emerging thematics that have accelerated growth profiles, in addition to higher upside earnings leverage given typical low industry market shares and cost structures. can lead to significant earnings and valuation upside over the long-term.”

That doesn’t make sense: if small caps’ earnings rose more quickly than mid and large caps,’ then their long-term return should exceed mid and large caps’.

Yet during the 21st century, Aussie small caps generally haven’t outperformed; accordingly, there’s no compelling reason to expect that their earnings (or the potential to grow their earnings) exceeds mid and large caps’.

And so say actual data: an analysis of Australian small caps undertaken by Schroders in 2017 found that in the preceding ten years “large-cap earnings … significantly outpaced small-cap earnings …”

Criticism 2: “You’re ignoring indexes’ changing composition”

Another possible criticism: “the SOI’s return is understated and the mid-cap index is overstated.

"Each quarter, these indexes rebalance: up-and-coming companies (whose market caps rise above the threshold for admission into the mid-cap index) graduate from the SOI; and fading companies (whose market caps fall below the mid-cap index’s lower bound) are relegated to the small-cap index.

"The effect of these movements inflates the mid-cap index’s return and depresses the SOI’s.”

That contention is plausible, but it’s also incomplete. There are not just two but four lanes of traffic: 

1. from the SOI to the mid-cap index
2. from the mid-cap index into the SOI 
3. from micro caps into the SOI
4. from the SOI into micro caps. 

All else equal, lanes 1 and 2 may decrease the SOI’s return. But other things aren’t equal: lanes 3 and 4 may increase the SOI’s return.

And because it’s probably easier to enter the SOI from below (which currently requires a market cap of ca. $115 million) than to leave it from above (which requires a market cap of $5-6 billion), the net effect of this four-way traffic more likely benefits than harms the SOI’s returns.

Criticism 3: “You’re ignoring small-cap managers’ long-term outperformance”

“Until recently,” stated Schroders in 2017, “the average active manager in Australian small caps have shown a startling propensity to outperform the small-cap index.”

Its analysis cited data showing that, before fees, “the median small-cap manager has outperformed by 7.32% per year over the last 10 years …”

In research published in July 2020, Morningstar reported that during the ten years to 30 June of last year its “medallist small-cap fund” managers outperformed their benchmark (SOI return of 4.57% per year) by 5.27% per year.

This outperformance is much more apparent than real. First, of the 45 managers surveyed by Schroders, only 23 possessed 10-year track records; in Morningstar’s research, just 16 did.

The tendency for poorly-performing funds to disappear from performance scorecards biases upwards the average result of those which remain – according to Schroders, by ca. 1.1-2.2 percentage points per annum.

If so, then the actual outperformance before fees of small-cap funds cited by Schroders is ca. 5.1-6.1% per year; of those cited by Morningstar, it’s 3.1-4.2% per year.

Secondly, “fees on small-cap portfolios can be quite significant in absolute terms, and are on average 60% higher … than large-cap portfolios.”

On a post-fee basis, the outperformance of small-cap funds decreases to ca. 2.7-3.7% per year; of those that Morningstar tracked, it sags to 0.7-1.8% per year.

And in the 12 months to 30 June 2020, the outperformance of the 18 small-cap funds tracked by Morningstar (the benchmark was -5.67%) was 3.35%; net of fees, that’s ca. 0.95%.

Morningstar concluded that “most active small-cap Australian equity managers handily small-cap indexes” in the decade to June 2020.

Taking survivorship, fees and volatility into consideration, the long-term results of investors in large cap index funds likely exceed those of their counterparts in actively-managed small cap funds.

Conclusions and implications

Earlier this year, a proponent of small caps advanced four overlapping assertions:

1. Small caps provide excellent opportunities in an inefficient market; they, therefore, offer attractive returns for successful stock pickers
2. They offer innovative management and technology; consequently, they possess the potential to transform industries and economies
3. Their fundamentals – particularly their growth potential – are more attractive than those of other market segments
4. For these reasons, Australian investors should consider small caps as part of a diversified portfolio.

None of these statements is unequivocally false, but the third one is very dubious. Equally, although cherry-picked anecdotes abound, systematic data don’t: accordingly, and in light of the data and results I’ve presented, investors shouldn’t regard either the first, second or the fourth claims as indisputably true.

It’s important to acknowledge that in the 12 months and five years to September 2021 the SOI has outperformed mid and large-cap indexes.

Since May 2020, however, the S&P/ASX100 has outpaced the SOI. Moreover, during the 21st century, the SOI has generated inferior long-term returns – and over some periods very poor returns – relative to the mid and large-cap indexes; moreover, throughout these years excessive variability has accompanied the SOI’s results. 

In conclusion, proponents of small caps cannot credibly contend that they generally offer outsized opportunities and returns. Speculators can and often do go for broke – but investors should tread carefully and shouldn’t go considerably overweight.

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At Leithner & Co., we believe in creating wealth through long-term consistent growth, built on trust and transparency. Our value investing approach allows us to learn from the past but keep our eye firmly on the future.

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